Week Eleven Class Notes

Resource based view of the firm and diversification into new markets

In this set of notes, you are going to get a whirlwind tour of resource analysis and a basis for thinking about diversification into new markets. Here is the motivation: strategy at the business level is concerned with why some firms perform better than others (usually performance is usually measured as profitability).  Firms that do perform better than their industry average are described as having a competitive advantage. Research indicates that while it is true some industries are more profitable than others (hence driving firm profitability to an extent), Dick Rumelt (a Harvard protégé of Michael Porter) showed that individual firm differences explained about three times more of the variability in profitability than did industry. That is, profit is firm specific.

Where do such profits come from? The Resource Based View (RBV) of the firm argues that resource heterogeneity is the source of variation in firm profits. When a firm is earning above average profits, it is doing so because it can compete (i.e., deploying particular resources to produce or service or sell) in a way that others cannot either by being able to command a price premium or produce at a very low cost. Competitors will note this and want to acquire the same production resources and get a share of those abnormal profits. As you'll see, if they can get the resources, the profits are shared and ultimately disappear. What happens if they cannot?  

Resources are a factor of production. Jay Barney describes them as "all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc. controlled by a firm that enable the firm to conceive of and implement strategies that improve its efficiency and effectiveness" (Barney, 1995) .  Generally, resources have classified as tangible or intangible. Barney distinguishes further between physical capital, human capital, and organizational capital. Tangible resources like physical capital are usually the first that come to mind when people develop examples but intangible resources like culture, leadership, and technology are usually the most valuable (Collis & Montgomery, 2008).

How does a resource differ from a competence or capability? This gets muddled in various perspectives. Peng argues (like Barney), that there is no difference and the terms are interchangeable. Others like the levels of difference implied. I follow and use this categorization (though I often call them all resources!):
  • A capability is something a firm is good at doing - -with the emphasis on doing. Thus, it is a resource but this notion of skill, process, or system distinguishes it from other, more tangible resources.
  • Competences are sometimes described as more complex, processual resources or combinations of capabilities.  Prahalad & Bettis (1986)  develop the notion of core competencies as a signature of the well diversified firm -  "the core competence is the thing that links the businesses"
  • An emerging field of inquiry is "dynamic capabilities" or the ability of firms to systematically learn and adapt to changing environments. This, too, is a resource.


Every firm has a vast array of resources and since most firms do not have a competitive advantage (why?), how can we determine which resources are the most important. The first step is to note that only firms with above average performance will have the resources we are interested in. The second step is to analyze those firms' resource portfolios to see how they do it. The model Peng introduces in Chapter 4 (VRIO) was developed by Barney and will be used here as a basis for discussion though I will be using a variant called VRIN.

The very first thing to do is to make sure you understand what the resource is. Take the time to reflect on it, define it, and understand how it is like/unlike competitors. Collis and Montgomery (2008) describe this as disaggregating. I can confirm that failure to do this leads to some real problems of scope of analysis.


The VRIN model

First, determine and stipulate how the resource is valuable to the firm. Barney (1995) says resources are valuable if they allow a firm to exploit an opportunity or negate a weakness. Collis and Montgomery (2008) argue a resource is valuable if "contributes to the production of something customer wants at a price they are willing to pay". Porter argues resources are not valuable in or of themselves - but because they allow firms to perform activities that create advantages in particular markets.  Thus, I tend to look at resources and ask if they provide cost savings or revenue enhancement relative to other ways of producing the product or service. Always look to be very specific about value - how you would (at least theoretically) measure it. In a case format, look for indicators such as comparative cost or revenue changes that affect margins.

Second, determine the extent to which the resource is rare in the industry. We want to know the degree to which the resource owner is alone in that. If everyone has the same or similar resources, then this is of no comparative, incremental value to the firm (e.g., since all firms in an industry likely have phone systems, having one cannot lead to performance differences. Such a resource may be necessary to being a good competitor but it can only be a source of parity). However, if the resource is rare then we have a quasi-monopoly. That is, it is valuable and generating rents in a way no one else is and conveys above average profits - hence a competitive advantage.

Third, determine whether the resource is inimitable:  can other firms, if lacking the resource, acquire it at a reasonable cost? That is, potential imitators don't want to acquire this for more than it is worth or more than they can make in above average returns. This is key - the question is not simply whether the resource be imitated or substituted but whether it can be done in an economically rational fashion. If it can, then the resource conveys only a temporary competitive advantage because others will acquire the key resource and share (and ultimately dissipate) the profits.

Finally, determine the extent to which the resource is Non-substitutable:  can other firms find a new way to achieve the same benefits with a different resource? That is, a substitute finds a way to meet the customer need in a different way than the focal resource. For example, Caterpillar (the manufacturer of earth moving equipment like graders and bulldozers) knew that customers really wanted fast delivery of replacement parts when their machines broke down (why? What did customers really want?) so Cat built a worldwide system of parts supply depots which no competitors could match.  However, would there be a way for another firm to meet the same customer need? Note: the same criterion vis a vis cost of substitution is imposed. Again, if the resource can be substituted, the competitive advantage is only temporary. Only if a resource passes all four tests will it provide a sustained advantage or long term, above average profits.


Diversification

This is not so much a discussion of Chapter 9 as a gloss on it because the topic is broadly diversification or the choice of which product/markets to compete in. The fundamental problem of diversification is that it often doesn't work! In general, the performance of diversified firms has been quite poor in the sense that owners (shareholders) have generally lost value rather than gained it from the decision firm managers have made in moving into new product-markets.  One (partial) explanation is that diversification always adds new costs of coordination to managing. So, in order for diversification to make sense, it must be the case that there are benefits to a particular combination of businesses that generate enough value to overcome the burden of added costs. If not, then managers are doing what shareholders could do at lower cost (this is called an agency problem).

One way diversifying managers can generate value is through sharing resources between SBUs to reduce costs. This is also called economies of scope or cost synergies and are derived from sharing resources, activities and competencies between SBUs without additional cost. For example, suppose again that Firm A acquires B and the firms are alike enough that A can market B's product line through the existing sales force and in existing distribution show rooms. Or, suppose that A can actually manufacture both A and B products in A's existing facilities (or produce A and B products in B's factories - it doesn't matter which way). In both events, the total cost of selling or producing both A and B products is less than it was when the two units were separate. The scope (or range of production) of the new firm is larger than the old which is why there can be savings.

Economies of scope aren't just about sharing tangible resources. Knowhow and experience can be shared as well and it should be reasonable to accept that this can reduce the overall costs of the firm as a whole, even though most of that benefit is realized in the SBU. Transferring competencies does face several problems, though. The more valuable potentially sharable competencies are, the more likely they are tacit or learned by experience and over time. They are "sticky" and since new SBU personnel may not share the same experiences, teaching and training can be difficult and costly. If so, the cost can exceed the benefit. Relatedly, learning new competencies requires both teachers and learners. The "teaching" SBU may privately not wish to free up the right resources. In other words, if the right people for training and knowledge transfer are also particularly valuable to the business unit and if managers are rewarded on unit performance, then the right people may not be released to the task. This degrades competence sharing and subsequent benefits.   The "learning" SBU may not value the new knowledge, or may resist the idea that learning is necessary. Again, the benefits of sharing would be eroded.

The connection to Chapter 9 is this: entrepreneurial firms considering international expansion can do this through the stage model (progressing from exporting through alliances, and so on) but when managers actually plan to enter another country as a going concern, they have to decide what resources will actually get transferred - or if relevant assets can be transferred. Here Peng's discussion of institutional and resource based perspectives is particularly useful.



References:

Barney, J. (1995). Looking inside for competitive advantage. Academy of Management Executive. Vol. 9, Iss. 4; p. 49  (AN 9512032192)

Collis, D. & Montgomery, C. (2008). Competing on Resources. Harvard Business Review, Vol. 86, Issue 7/8, p140-150 (AN 32709010)

Porter, M. (1979). The Structure within Industries and Companies Performance . The Review of Economics and Statistics. Vol. 61, Iss. 2; p. 214 (AN 4650217)

Prahald, C. & Bettis, R. (1986). The Dominant Logic: A New Linkage Between Diversity and Performance.
Strategic Management Journal.  Vol. 7, Iss. 6; p. 485

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